Cutting Through the Bull

Equities are claims on real assets and the cash flows that these assets generate.
As a result, the nominal prices of equities can be, and often are, boosted
when excessive growth in the supply of money (inflation) causes the currency
to lose purchasing power. To avoid being hoodwinked by the effects of inflation
we therefore need to find ways to monitor the stock market's REAL trend (the
trend after the effects of inflation are properly accounted for). After all,
if the nominal price of an investment rises by 10% during a period when the
value of the currency in which the investment is priced falls by 20%, then
despite the nominal price gain the owner of this investment will suffer a reduction
in real wealth.

As we've explained many times over the years, one of the best ways to see
what's really happening to the stock market is to look at long-term valuation
trends. In particular, we can effectively remove the distorting effects of
inflation from our interpretation of the stock market's long-term trend by
defining a secular bull market as a generational (15-25 year) trend toward
higher valuations and defining a secular bear market as a generational trend
toward lower valuations. One reason is that lower valuations (lower multiples
of earnings, sales, book value and dividends) are invariably assigned to stocks
during periods when a large chunk of corporate profit growth is perceived by
the investment community to be the result of inflation.

With the above definitions of the secular trend in hand, a look at what has
happened to the US stock market's average valuation over the past 80 years
will reveal that: a secular bear market commenced in 1929; a secular bull market
commenced in the mid-1940s; a secular bear market commenced in the mid-1960s;
a secular bull market commenced in the early-1980s; and a secular bear market
commenced during 1999-2001.

Interestingly, but not surprisingly for anyone who understands the nature
of gold, when the US stock market's performance is measured in gold terms its
long-term trends roughly line-up with the aforementioned long-term valuation
trends. Therefore, secular trends in the US stock market can also be seen by
looking at long-term charts of the Dow/gold ratio.

Now, in previous commentaries we've used charts to illustrate the links between
long-term valuation trends, trends in the Dow/gold ratio, and secular bull/bear
markets. Such charts are, in essence, ways of viewing the stock market's real
(inflation-adjusted) performance over the long-term*. It recently occurred
to us, however, that an important long-term chart that we have never looked
at in the TSI commentaries is the Dow Industrials Index adjusted for changes
in the total supply of money. In other words, it occurred to us that we've
shown surrogates for the inflation-adjusted Dow on many occasions but have
never shown the actual inflation-adjusted Dow. We are about to remedy this
omission.

Below is a chart of the Dow/M3 ratio (the Dow Industrials Index divided by
the total US money supply). Unfortunately, we don't have M3 data prior to 1959,
but the data we do have is enough to tell us that long-term trends in the inflation-adjusted
Dow mesh quite well with the valuation and Dow/gold trends discussed above.

The bottom line is that whichever way we look at it we see that US equities
are presently about 7 years into a secular bear market.

Before leaving the subject of how money-supply growth can create the appearance
of a bull market where no bull market exists it is appropriate to address a
related issue: the general misconception about the relationship between capitalism
and rising asset prices.

It has been mentioned in several quarters that the global rise in equity prices
indicates the spread of capitalism. The implication, here, is that capitalism
leads to higher asset prices. Well, we've come across a lot of analytical hogwash
in our time but this comes close to 'taking the cake'.

Capitalism has many characteristics, but at the end of the day it is really
just an economic system based on the total and consistent application of property
rights. The main driver of the upward trend in nominal prices, on the other
hand, is government-sponsored inflation; and government-sponsored inflation
is a gross VIOLATION of property rights (inflation is a form of theft because
it reduces peoples' real monetary savings just as effectively as if a portion
of these savings were being physically stolen). Furthermore, when we look at
what has happened to the stock markets of various countries around the world
we can actually observe an INVERSE correlation between stock market gains and
the extent to which property rights are upheld. Zimbabwe is the most blatant
example of this inverse correlation, but China and Russia -- two countries
that have provided equity market investors with phenomenal gains over the past
few years -- are also good examples. On a superficial level it may appear as
if capitalism is thriving in China and Russia, but a property right that's
likely to vanish the moment you utter a word against the government is not
a genuine right at all.

Capitalism lays the foundation for strong REAL growth whereas rapid across-the-board
gains in asset prices are generally the result of inflation. Don't confuse
one with the other.

*Note that when creating an inflation-adjusted picture it makes absolutely
no sense to use the price indices reported by the government because these
price indices are meaningless.